Pricing Diagnosis‐Based Services When Customers Exhibit Sunk Cost Bias

Abstract

Significant evidence has emerged that consumers are boundedly rational and display a sunk cost bias when making decisions. Moreover, customers may display dynamically inconsistent beliefs about the extent to which they will discount sunk costs. We evaluate the impact of sunk cost bias and dynamically inconsistent preferences on commonly used pricing schemes in a service setting with diagnosis and treatment phases. Using a two‐part tariff pricing scheme, a monopolist service provider can achieve higher profits by exploiting the dynamic inconsistency of customers in their sunk cost bias proclivity. In fact, the provider can achieve higher profits when sunk cost bias is higher or the dynamic inconsistency is greater. In contrast, the provider's profit is lower when sunk cost bias is higher under a single rate time‐based fee. We evaluate special cases of the two‐part tariff frequently used in practice such as conditional diagnosis fee, single rate time‐based fee, and free diagnosis and characterize their relative performance under different levels of bounded rationality. A conditional diagnosis fee, which is charged only if a customer leaves after diagnosis without treatment, does very well. Offering a free diagnosis and charging a high rate for treatment performs poorly. We also provide insights into a setting in which the market consists of two customer classes with different levels of sunk cost bias or dynamic inconsistency in preferences. Overall, we show that sunk cost bias and inconsistency in beliefs over time are important factors that a provider should carefully consider in choosing a pricing scheme.